In case you haven’t noticed, there are BABs in Bondland.

“Build America Bonds” were created by Congress under The American Recovery and Reinvestment Act passed last year.(1)  They’re municipals with a twist: unlike traditional bonds issued by state and local governments, the interest on BABs is taxable instead of tax-free. As you might expect, this makes them pretty unattractive to typical muni investors, that is, folks in the top tax brackets looking to avoid losing more than a third of the interest earned to federal income tax.

None-the-less, non-traditional buyers, those who pay no or little federal income tax, are snapping them up.

Craig Brandon, manager of Eaton Vance’s Build America Bonds mutual fund, says BABs have created “a whole new market” of municipal-bond investors, including pension funds, foreign governments and corporations, as well as individual investors in the lower tax brackets.

To make it more affordable for cash-strapped cities and states to take on new debt, the federal government is picking up 35-percent of the interest. Thus, if the interest on a BAB is 7%, the cost to the issuer is 4.55% (5.00%-.35%). The investor, of course, receives the full 7%.

According to Dino Mallas, portfolio manager in the municipal bond department at mutual fund family T. Rowe Price, approximately $121 billion of BABs have been issued since the first one came out in April 2009. By law, the money raised must be used to fund construction projects, thus fulfilling the goal of “stimulating” the economy by creating jobs.

So what’s not to love?

For one thing, just because the federal government is subsidizing the interest payments, don’t confuse a BAB with a Treasury bond.

“We’re hearing that retail investors think this is security guaranteed by the U.S. treasury or U.S. government,” says Mallas. “It’s not.” Neither the interest payments nor the return of principal are guaranteed, although he stresses that the municipal bond market has historically had a very low default rate.

Brandon maintains that, despite the fact that state and local governments are grappling with the worst budget shortfalls in history, it’s unlikely we’ll see a surge in defaults.

Take the extreme case: California. “If you’re the state of California, [defaulting] only gets you $5-6 billion… when you have a $20 billion hole,” Mallas says. “If you eliminate 100% of California’s debt, hat only solves 25% of its deficit problem. They have a spending problem, not a debt problem.”

Both managers assert that for investors who don’t need tax-exempt income, BABs offer a way to diversify bond holdings and potentially reduce your overall risk. Although T. Rowe Price doesn’t have a mutual fund specifically devoted to Build America Bonds, Mallas says they are held by some of the firm’s taxable bond funds. 

In addition, BABs might pay you higher income than a corporate bond with a similar risk rating. Brandon points to an A1-rated state of Illinois BAB issued last week with a yield of 7.11% and a maturity date of 2035. By comparison, an Abbot Labs corporate bond due in 2039 and trading in the secondary market has the same rating but a yield of just 5.16%.

He adds, “I’m not saying ‘Sell all of your corporate bonds.’ [I’m suggesting you] diversify some risk [by moving into] the muni market and picking up a little more income.”

Next week: BABs are not without controversy.  Unless Congress acts, the federal subsidy- and, thus, the issuance of new BABs- expires at the end of this year. Why you might be glad if that happened.

1. Technically, The Economic Recovery and Reinvestment Act of 2009. '



Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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